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A name brand at a cigar butt price

What investor wouldn't want to own a piece of a name brand company? Selling an investment story on a recognizable name is much easier than selling the story on Murphy's Midwest Muffler Repair, no matter how cheap the company is. Harry & David (HARR) is unique in that they have a well known brand and the company is cheap being newly issued equity from a bankruptcy re-organization.

For anyone who isn't familiar, Harry & David sells specialty gift baskets. The company's known for gift baskets that include their Royal Riviera pears. For anyone doubting the power of their brand just browser their catalog, they sell nine pears in a nice box for $24! Like with most things it would be much cheaper to assemble a gift basket oneself, but that would defeat the point. Gift baskets are an easy way for someone to pay a small fee and send a message to person that they're appreciated (or they appreciate their business). The company has a variety of baskets for holidays throughout the year, but the Thanksgiving to Christmas period is when the company sells most of their baskets.

The majority of the company's sales are through their catalog and the internet. They also operate 55 stores located throughout the country. The stores accounted for 12% of sales last quarter. The company also operates orchards to grow their famous pears. The company's orchards contain 725,000 pear trees located in the Rogue River Valley of Oregon.

In a cyclical business that's highly levered a small downturn in demand can result in a company tripping their debt covenants; which is what happened to Harry and David in 2011. The company experienced reduced demand in Q2 2011 and the result was a default on a $105m loan. The company went through bankruptcy and restructured their balance sheet resulting in $276m worth of pre-petition obligations settled and wiped clean. The company now has no long term debt, and no pension liabilities. The company does have a few settlement payments left to the PBGC, but they will be completely satisfied in 2014.

Out of the bankruptcy re-organization senior note holders were offered rights to purchase 76% of the newly issued common stock. As part of the restructuring process the company qualified for fresh start accounting. This means the entity was revalued given a specific point in time coinciding with the emergence from bankruptcy. The valuers looked at the company from the perspective of what might they be worth in a sale today? Here is a picture of the valuation, and the numbers that went into it:

What makes Harry & David interesting is not their story but their valuation, their market cap is $84m. The current balance sheet had $89m in cash, and if an enterprise value were calculated off their last balance sheet it would be close to $4m. And based on the most recent quarter they have a EV/EBIT of .07x. As I mentioned above the company is extremely seasonal, they make most of their money around the holidays then steadily lose money the rest of the year. This year was no different, they made $41m in the last quarter, and will most likely lose $10m in each of the other three quarters.

I have a spreadsheet with results going back to the emergence from bankruptcy below. A general note, if you try to add the quarterly numbers for 2011 together to match the fiscal numbers they won't match. One of the quarters had different dates from the fiscal year meaning the time periods aren't the exact same. That detail doesn't matter specifically, I put this together to grab the seasonal trend.

The trend in the results is clearly apparent. The company makes a haul at Christmas and then steadily spends down the cash and loses money the rest of the year. If the losses are less that what they made at the holidays they turn a profit at the end of the year.

A side effect of this feast and famine cycle is as the company spends down their cash each quarter they end up in a position where it becomes hard to finance working capital. Especially in preparation for the holiday season. Because of this the company carries a revolver which they tap each June to December. In January the revolver is paid back and the company operates on a cash basis until June.

Valuing Harry & David

When I'm looking at a company's earnings I like to use the EV/EBIT multiple because it cuts through extra cash, includes financing and shows what I consider core earning power. This metric is especially useful when looking at little cash boxes, something I do often.

Calculating an accurate enterprise value for Harry & David is difficult, what point in time should an investor use? Should we extrapolate a $12m loss forward for the next two quarters and use a projected $65m cash balance for the end of the fiscal year? Figuring out earnings or EBIT is much easier because the proper way to view them is over the entire year.

I re-valued the company using the same methodology that was used when they emerged from bankruptcy but I used figures from the latest quarter:

While I've never tried to value a company with this method before it's nice to see that the number it generated is very close to the company's book value for the last quarter. If nothing else the fresh start valuation methods reinforce the company's book value.

One other item worth noting is the company's liabilities could be potentially overstated as they carry $36m in deferred revenue on the balance sheet. It's likely they will recognize this revenue considering they received most of the cash for it already.

Worth it?

The company appears cheap, they're trading at 71% of book value, or 60% of adjusted book value taking into account the deferred revenue they've received as cash. On an asset basis the company certainly merits consideration as an investment.

Unfortunately for me the story stops there, while the company has considerable brand power, and is trading at a large discount to asset value there is an intangible that I can't ignore, their financing decisions. Due to the nature of the company's business they are forced to continue the same patterns that led them into bankruptcy the last time. They still have a revolver they tap in the summer and pay back after New Years. If sales were to decline again like they did in 2011 the company could find themselves in a position again where they might be in breach of a debt covenant.

The other issue I have is while the company has a profitable niche that's all they have. Unfortunately their cost structure for this niche doesn't leave much profit left over for shareholders at the end of the full year. The company has pushed harder into the online marketplace, but they've had to reduce prices to push volume impacting margins.

I think Harry & David holds a lot of potential for many value investors, but for me it's a pass.